fOcus INVESTING AGAINST THE FLOW

fOcus
August 2016
Investing against the flow
HIGHLIGHTS
—— Buy low, sell high. This investment
strategy, which consists of purchasing
inexpensive shares and selling them at a
higher price once investors realise their
true value, is the only way to outperform
the market in the long run.
—— It requires an understanding of why
good
companies
are
sometimes
undervalued, so that « hidden gems » can
be distinguished from « value traps ».
MICHAEL CLEMENTS, cFA
—— A longer investment horizon must be
adopted in order to give good investment
ideas the time they need to pay off.
" Patience is a real virtue, as shares are
usually held in a portfolio for three or five
years-often at low price levels. Investors
need to be loyal and composed."
European Equities Expert
Give time some time
Every fund manager wants to outperform the market.
But how can one make a difference against the
hundreds of competitors fighting to get ahead of the
herd ? One way is to have more information than the
competition, but, in this age of instant information, it
is either impossible or illegal. Another option is to do
a better job at analysing the information, also quite a
challenge considering the massive amount of research
carried out daily by thousands of analysts worldwide.
Therefore, the only realistic solution to beat the market
seems to be to adopt a longer time horizon in order
to allow good ideas sufficient time to deliver on their
promises.
Buying low
As every wannabe investor knows, the key to success
is to buy low and to sell high. This self-evident fact
hides a painful truth : buying low is easier said than
done. Indeed, it requires great courage to resist peer
pressure and avoid fashionable but expensive stocks.
More importantly, it also entails buying companies that
nobody likes or investing in times of panic. Above all,
it means being patient. Very patient. It involves doing
your homework and then waiting for the right time
to buy. Waiting for the market to fall, so you can find
a good entry point. And then wait some more, years
sometimes, until the market changes its mind and
analysts realise what a great company your investment
really is.
Avoid cheap becoming cheaper
Unfortunately, cheap stocks can stay cheap for a long
time. If you’re a fund manager, you can convince your
investors to show some perseverance and wait until the
rest of the market sees the light. Of course, you need to
hold your nerve to stay on the side-lines when the rest
of the market rises and companies which you consider
way too expensive continue to make daily gains. What
your investors will never accept, however, is to see your
“hidden jewels” stocks turn out to be “value traps” –
companies that look cheap but are in fact suffering
from a structural deterioration in their business model.
As a result, when investing for the longer term, it is
absolutely essential to minimize downside risk and
avoid sharp drawdowns. The way to achieve this is
through extensive and demanding analytical research
in order to understand the drivers of the company’s
performance, assess the soundness of its balance sheet
and perform in-depth “worst-case scenario” simulations.
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SYZ Wealth Management
Tel. +41 (0)58 799 10 00 - [email protected]
Please refer to the complete disclaimer
FOCUs
August 2016
Cherry-picking companies for the long run
The two key criteria for selecting the right stocks are
quite straightforward. The first rule is to buy high
quality companies and the second is to buy them at an
attractive valuation. This seems self-evident but, as is
often the case, it’s easier said than done. What makes
a company good ? If you’re going to invest for the long
term, you need a business that has a fundamentally
sustainable competitive advantage. This can mean a
strong brand, like LVMH, market dominance that gives
pricing power, like Legrand, a low cost provider, like
Easyjet, or having a technological advantage, like Sanofi.
In order to get the other side of the equation - attractive
valuation - right, you need to focus on free cash flow
generation as it’s the real engine to wealth creation and
is less susceptible to accounting manipulation.
Understanding why it’s cheap
Unfortunately, good companies generating a lot of free
cash flow that are attractively valued do not grow on
trees. It’s therefore important to understand why at
times this may be the case. There are basically three
possible reasons : negative investor sentiment against
the country or the sector (as was the case for Spain after
2008) ; negative sentiment due to cyclical or “flight to
safety” reasons when investors indiscriminately rush
out of equities ; or company specific fears around its
business model. Once the reason for the cheap valuation
is determined, you can assess whether it’s justified
or not.
The sentiment cycle
Long-term contrarian investing relies on sentiment ;
and sentiment follows a cycle that in turn will guide the
investment cycle.
SENTIMENT
PEAKING
SENTIMENT
IMPROVING
SENTIMENT
WEAKENING
The sentiment weakening phase is usually triggered by a
crisis, and represents the long-term buying stage, when
positions are initiated by contrarian investors. Gains
are unlikely to be made at this stage, which should be
viewed more as an opportunity to buy low than to sell
high, as this stage can last for years. Examples that lead
to building these types of positions are the Spanish crisis
and, more recently, the emerging markets confidence
crisis and the oil price collapse. Besides a weakening of
country- or sector-wide sentiment, one can also look at
company-specific opportunities by monitoring for the
most short-sold stocks, as was recently the case with
Swatch Group. Such long-term stories can represent
about one third of the total portfolio and, similar to a
pharmaceutical company, are the future performance
pipeline for a contrarian fund.
The improving sentiment phase is potentially triggered
by a number of catalysts, and is the the point when
stocks start to take off. This stage is when good
investment ideas come to fruition and is the real driver
of outperformance. For instance, as the market has
become more confident since the start of the year on
the outlook for construction in Europe stocks such as
Legrand, Schneider or Rexel, which feature at the end of
the building process, are now taking off.
Of course, no investment strategy would be complete
without an exit policy. For a contrarian investor, the sell
or profit-taking signals start blinking when we reach the
sentiment peaking phase, which usually happens when
there is a positive consensus about a sector or market
and share prices are fully valued. We currently see such
a situation in the auto industry.
Investors sometimes worry that a long-term focused
contrarian portfolio will also take years to show a good
return. Actually, what tends to happen in practice is
that whilst it is true that the part of the portfolio which
is invested in stocks that are currently suffering from
negative sentiment trade sideways or even down in the
short term, this is more than compensated by the good
returns generated by stocks in the sentiment improving
or sentiment peaking phase. This helps to minimise
drawdowns and also dampens volatility.
The proof is in the investment pudding
Like all good investment ideas, contrarian investing relies
on basic common sense and appears simple enough. Of
course, what appears effortless in fact requires a huge
amount of work, courage and discipline. More than
anywhere else, patience is really a virtue as positions
are usually held for 3 to 5 years, many of them at the
initial low price stage, which requires nerves of steel
and loyal investors. But significant outperformance and
low volatility are the rewards to be reaped.
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